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"Insurance rate cut" by Fed may be on the horizon

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      By Brian S. Ellis, CFACalvert Fixed Income Portfolio Manager and Vishal Khanduja, CFADirector of Investment Grade Fixed-Income Portfolio Management and Trading, Calvert Research and Management

      Boston - From our perspective, the main story of the second quarter was the downdraft in rates. Global bond yields moved substantially lower, driven by renewed U.S.-China trade tensions, weaker U.S. and global economic data, and dovish central banks.

      In the U.S., yields declined across the Treasury curve, with the 10-year trading below 2% for the first time since 2016. Two-year rates fell more than 10-year rates, resulting in a modest curve steepening. Overseas, Japanese sovereign debt yields sank deeper into negative territory, and rates fell to record lows across much of Europe — which, in several countries, meant they also became more negative. The global value of negative-yielding bonds topped $13 trillion in June, an all-time high according to Bloomberg.

      The fall in rates was driven by renewed U.S.-China trade tensions, weaker U.S. and global economic data, and dovish central banks. After months of negotiations, U.S.-China trade talks broke down in early May, prompting a series of retaliatory actions by both countries. Meanwhile, consumer confidence, durable goods orders and manufacturing activity softened in the U.S., while eurozone manufacturing activity continued to contract and Chinese imports slumped.

      As trade tensions escalated and economic data weakened, markets began to anticipate an "insurance cut" from the Federal Reserve (the Fed) — i.e., a cut in the fed funds rate aimed at pre-empting a more pronounced U.S. slowdown. At quarter-end, markets were pricing in four rate cuts by April 2020, with the first happening at the Federal Open Market Committee's (FOMC) July 30-31 meeting.

      ratecut

      Chart reflects market-implied probabilities for the fed funds rate. Source Bloomberg as of 7/30/19.

      Although the FOMC held policy steady throughout the quarter, it signaled a willingness to cut rates to extend the expansion. Similar to the Fed, the European Central Bank (ECB) did not take any new action but suggested it might cut rates and potentially restart bond purchases. Central banks in several countries, including Australia and India, lowered rates.

      We agree that the Fed's next move will likely be an easing. However, we think what markets are expecting in terms of the timing and magnitude of future cuts is too aggressive. We also think markets may be overestimating the efficacy of Fed policy in the current environment. Inflation certainly has room to move higher, but unemployment is at its lowest level in about 50 years. So rate cuts may not be as economically stimulative as they have been in the past.

      We believe expectations for monetary easing should provide near-term technical support for bond valuations. However, we don't think it's prudent to be investing in risk assets over the next six to 12 months thinking that the Fed can halt an eventual economic downturn. As a result, we have not been adding risk to portfolios. Portfolios are neutral to slightly underweight duration given the big move in rates and, at the margin, are positioned for additional yield-curve steepening. We think inflation assets continue to look attractive because of where we are in the cycle and because of the possible inflationary effects of trade tariffs and any Fed easing. Consequently, portfolios remain overweight Treasury Inflation-Protected Securities (TIPS).

      Portfolios are also still overweight securities linked to consumer balance sheets, as low unemployment should continue and wage growth has improved. For that reason, we view asset-backed securities tied to consumers as providing attractive spreads and potential stability for portfolios. On the corporate side, we prefer financials over non-financials this late in the cycle. We believe a focus on security selection will add value in the months ahead as markets anticipate the Fed's next move, and as U.S.-China trade talks resume.

      Bottom line: Economic and geopolitical uncertainty remains elevated, yields and risk assets have rallied significantly, and we are in the late stages of the credit cycle. We believe a focus on security selection will add value in the months ahead as markets anticipate the Fed's next move, and as U.S.-China trade talks resume.

      Investing involves risk including the risk of loss. As interest rates rise, the value of certain income investments is likely to decline. Investments in debt instruments may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non-payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.